Creating a "Sinking Fund" in an ESOP to Fund Repurchase Obligations

One of the ways to fund ESOP repurchase obligations is to create a "sinking fund" in the ESOP. This involves making contributions to the ESOP that are greater than what is needed on a current basis for distributions, thereby creating a fund that can be used to meet future liquidity needs. These contributions are allocated to participants' accounts, and when distributions are made to terminated participants, the trustee uses them as the source of liquidity, in effect buying the shares from the terminated participants with cash from the remaining participants' accounts. The advantage of this approach is that, with proper planning, it can make the repurchase obligation expense one that is more level and predictable than it would be if it were funded on a "pay-as-you-go" basis. It can make sense to fund in this way when the circumstances are right, and when contributions are kept within appropriate limits.

A necessary step in planning for this (or any other) type of funding is to project the future repurchase obligations that the company will face over at least a 10 year period. (Obviously, such long-term projections will never be totally accurate, but they will help you to estimate the timing and magnitude of repurchases.) Analyze the projected repurchase obligations in the context of payroll and other benefits by measuring them as a percentage of projected covered compensation. Not only does this help you keep the numbers in perspective, but it is also how benefit expenses are often measured and how funding limitations are expressed. This will allow you to determine the annual amount of contributions (usually expressed as a percentage of covered compensation) that will be needed to fund the repurchases. You will also need to take into account the expected rate of return on non-company-stock investments in the plan when doing this analysis.

Under what circumstances does it make sense to create a sinking fund in the ESOP? The main criterion is that the company must intend to recirculate shares in the ESOP, i.e., to handle repurchases within the trust rather than having the trust distribute shares in order for the company to redeem them. It makes no sense to fund this way if the intention is for the shares to be repurchased outside the trust. In addition, the company must have the intention of making ongoing contributions to some type of qualified retirement benefit plan on behalf of its employees. Finally, repurchase obligations that are "lumpy" (i.e., they tend to vary a lot from year to year) particularly lend themselves to this type of funding.

One of the advantages of funding repurchases through the ESOP (i.e., recirculating shares) is that the contributions that are made to the trust are deductible, assuming they are within the statutorily prescribed limits, and the investment earnings within the trust are not taxed. For C corporation ESOPS this results in lower costs than handling repurchases by redeeming shares with after tax dollars, though it is of little or no importance for S corporations with large percentage ESOP ownership.

All of the contributions that the company makes to the ESOP trust to fund future repurchase obligations are allocated to participant accounts. As a result, individual participants' accounts increase from these contributions. This creates a potential solution to one problem, as well as potentially creating another problem.

The problem that is potentially solved is one that is faced by many mature ESOPs - how to systematically get shares to new participants when there is no more stock in loan suspense and the only shares available for allocation are from forfeitures and repurchases. When repurchases are funded through the ESOP, shares reach new participants as the recirculated shares are reallocated. But how those shares are allocated depends on whether the repurchases are being funded on a pay-as-you-go basis or with a sinking fund.

If pay-as-you-go funding is used, then the company will contribute the amount needed for repurchases in that year and all of the shares repurchased will be allocated to that year's eligible participants according to the ESOP's allocation formula, which is typically pro rata to compensation. If repurchases are "lumpy," so will be the contributions and the allocations. Most companies like to have more consistent contributions to their retirement plans.

By contrast, when funding is through a sinking fund in the ESOP, repurchases are funded from the accumulated non-company-stock investments in the trust. The trustee takes funds from the trust, pro rata to the other investment accounts to purchase the shares, and allocates the repurchased shares in the same proportion. The result is that the number of shares that participants receive from repurchases is related to their accumulated account values, which in turn is related not only to their compensation, but also to how long they have participated in the plan.

One of the potential drawbacks to the sinking fund in the ESOP is that when participants terminate employment, they are entitled to the full balance in their account - including the cash that has accumulated. So, the cash balances in the plan are depleted not only by the value of the stock that has to be repurchased, but also by the amount of the cash accounts of the terminated participants. Some argue that this defeats the purpose of creating the sinking fund. But does it really? After all, the ESOP is a retirement plan, and the idea is to create and distribute benefits for the participants. If the contributions are limited to an amount with which the company is comfortable as a retirement plan contribution and the ESOP is used instead of another plan, then this purpose is well served. It's only when excessively high contributions are made to the ESOP in an attempt to accumulate a sinking fund that the cash accounts pose a problem. This argues in favor of using a combination of funding methods when the projected repurchase obligations would require too high a level of contributions to the ESOP.

Another drawback to a sinking fund in the ESOP is that it limits the flexibility in repurchase methods. It only is useful if you plan to recirculate shares by handling repurchases through the ESOP. Once the contribution has been made to the ESOP, the company can't retrieve it to use it to fund redemptions (or for any other purpose), so you need to be reasonably sure that you want to handle repurchases through the ESOP. By contrast, funding outside of the ESOP gives you more flexibility to handle repurchases within or outside of the ESOP.

Finally, you need to keep in mind that the legal obligation to repurchase shares rests with the company, and the ESOP trustee is not obligated to use the cash balances in the trust to fund repurchases (unless the plan document specifically requires it.) The trustee is obligated to act in the best interest of the plan's participants and must make that determination when using the cash balances to fund distributions.

A sinking fund in the ESOP is just one of a number of possible ways to fund repurchase obligations. Other approaches include a sinking fund or insurance outside of the ESOP, releveraging the ESOP or using debt in other ways, creating internal markets, or simply handling repurchase obligations on a pay-as-you-go basis. Developing a funding strategy requires that you understand the magnitude and timing of the repurchase obligations, the company's objectives with respect to the ESOP and employee benefits, and the company's financial capacity to meet the repurchase obligations. Planning for repurchase obligations should be integrated into the corporation's overall financial and strategic planning.